1.3The Higher the Risk That an Asset Has, the Lower the Demand for the Asset, Which Raises

1.3The higher the risk that an asset has, the lower the demand for the asset, which raises the yield or return. Low-risk assets have a high demand, which lowers their yield or return. So, for an investor to attain a higher expected return, the investor typically has to accept greater risk.

1.4Market risk is the risk that is common to all assets of a certain type because of shared economic conditions. Idiosyncratic risk is the risk that pertains to a particular asset, such as an individual stock, rather than to the market as a whole. Diversification is the process by which individuals or firms allocate savings among many different assets. Diversification reduces risk because when investors purchase a variety of different assets, if one asset performs poorly the rest of the portfolio may perform well.

2.1The demand curve for bonds will shift to the left when any of following occurs:
1.Wealth decreases.
2.The expected returns on bonds relative to other assets decreases.
3.The expected inflation rate increases.
4.The risk on bonds relative to other assets increases.
5.The liquidity of bonds relative to other assets decreases.
6.The cost of obtaining information on bonds relative to the cost of obtaining information on other assets increases.

The supply curve for bonds will shift to the right when any of the following occurs:
1.The expected profitability of physical capital investments increases.
2.Business taxes decrease.
3.Investment tax credits increase.
4.Expected inflation increases.
5.Government borrowing increases.

2.2The bond supply curve slopes up because as the price of bonds increases, their interest rates will fall, and holders of existing bonds will be more willing to sell them. Also, firms will find it less expensive to borrow at the lower interest rate and will issue more bonds. For both of these reasons, the quantity of bonds supplied will increase. The bond demand curve slopes down because as the price of bonds increases, the interest rates on the bonds will fall, and the bonds will become less desirable to investors, so the quantity demanded will decrease.

2.5a.The expected inflation rate will increase, so the demand curve will shift to the left, and the supply curve will shift to the right.
b.The expected profitability of physical capital investment has increased, so the supply curve shifts to the right.
c.The federal government will be redeeming more bonds than it issues, so the supply curve ill shift to the left.
d.The relative risk of investing in bonds has increased, so the demand curve will shift to the left.
e.The return to investing in bonds has been decreased and the cost of issuing bonds has been increased, so the demand curve will shift to the left, and the supply curve will also shift to the left.

3.1Interest rates typically fall during recessions. As the graph below shows, the demand curve for bonds shifts to the left from D1 to D2 because households experience declining wealth, and the supply curve for bonds shifts to the left from S1 to S2 because businesses have fewer profitable opportunities during a recession. For interest rates to fall, the price of bonds must rise, so the shift in the supply curve must be larger than the shift in the demand curves, as is illustrated in this graph:

3.2According to the Fisher effect, the nominal interest rate rises or falls point for point with changes in the expected inflation rate. An increase in the expected inflation rate causes the demand curve to shift to the left from D1 to D2, and the supply curve to shift to the right from S1 to S2. As a result, the price of bonds falls and the interest rate on bonds rises. This graph shows the Fisher effect working exactly, with the change in the expected inflation rate leaving the quantity of bonds unchanged:

3.3a.The demand curve will shift to the right, and the supply curve will shift to the left. The price increases, but it is unclear what happens to the equilibrium quantity. If the shift of the demand curve is greater than the shift of the supply curve, the equilibrium price will rise. If the shift of the supply curve is greater than the shift of the demand curve, the equilibrium price will fall.

b.The demand curve will shift to the right right with the increase in wealth resulting from the expansion, and the supply curve will shift to the right with the increase in profitable opportunities. During economic expansions interest rates typically rise, so the price of bonds will likely fall, implying that the shift in the supply curve is greater than the shift in the demand curve. The equilibrium quantity of bonds increases.

c.The supply curve shifts to the left, and the demand curve shifts to the right. The price of bonds rises, but the equilibrium quantity of bonds may rise, fall, or remain unchanged depending on the whether the demand curve or the supply curve shifts further.

d.The supply curve shifts to the right, forcing the price of bonds down and the quantity of bonds up. This result assumes no increase in household saving in response to higher expected future taxes as a result of the budget deficit.

4.2The demand curve is downward sloping because the higher the interest rate, the smaller the quantity of funds demanded because the cost of borrowing is higher. The supply curve is upward sloping because the higher the interest rate, the larger the quantity of funds suppliers are willing to lend.

4.4a.As shown in the graph below, the demand curve for loanable funds shifts to the right, from to , raising the world real interest rate from rw1 to rw2.

b.The supply curve for loanable funds would also shift to the right, from to The world real interest rate will fall from the equilibrium in part (a).to an undetermined equilibrium (for example, E3), depending on how much households increase their saving. See the graph below.

4.6a.The demand for loanable funds increases, increasing the equilibrium interest rate.

b.The demand for loanable funds decreases, decreasing the equilibrium interest rate.

c.The supply of loanable funds increases, decreasing the equilibrium interest rate.

d.The supply of loanable funds decreases, increasing the equilibrium interest rate.